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The Best ETFs for 2010

Exchange-traded funds typically have much lower expenses than ordinary mutual funds, and they give you much more trading control. But there are first-class ETFs, and there are lousy ones. Some ETFs -- especially those that seek to deliver two or three times an index’s performance -- are dangerous. Others invest in absurdly narrow sectors.

In picking ETFs, start with Vanguard’s. For index ETFs, there’s often no reason to look anywhere else. Vanguard’s not-for-profit structure generally makes it difficult for other fund companies to compete -- at least on expenses, which is the major consideration when choosing among index funds.

Here’s how to assemble an ETF portfolio for 2010. Start by staying with broad-based funds. Invest 55% of your stock money in Vanguard Total Stock Market ETF (symbol VTI). This fund tracks the MSCI Broad Market index, which reflects the entire U.S. stock market. Over the past 12 months through January 8, it returned 31%.

Like all the ETFs in this article, the weighting of its holdings is based on the market value of each stock (the share price times number of shares outstanding) in its universe. Thus, ExxonMobil, the nation’s biggest stock, represents almost 3% of the fund, while even a stock as widely held as Oracle makes up just 0.7%. Large-capitalization stocks, including mega caps, dominate this ETF, but it holds more than 3,300 companies, so 8% of its assets are in stocks of small companies. Annual expenses are a thrifty 0.09%.

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Speaking of mega caps, the largest companies now have a bigger advantage than usual over small companies. At a time when banks are still reluctant to lend, large companies have easier access to capital. What’s more, mega caps do a lot more business in fast-growing emerging markets than smaller companies.

Make a wager on growth stocks this year. Growth stocks typically command higher price-earnings ratios than do value stocks -- those that sell at low multiples to earnings, sales or other fundamental measures -- but they exhibit higher growth rates.

Here’s the rationale for overweighting growth: Currently, the amount by which P/Es of growth stocks exceed those of value stocks is much less than usual. Look for that gap to widen over time.

Boost your allocation to big-cap growth stocks by investing 10% of your stock money in Vanguard Mega Cap 300 Growth ETF (MGK). It tracks the MSCI U.S. Large-Cap Growth index, which is made up of the nation’s biggest growth stocks -- behemoths such as Microsoft, Wal-Mart Stores and Johnson & Johnson. Despite its name, the ETF recently held just 178 stocks. Its expense ratio is 0.13%. The fund surged 36% over the past 12 months.

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Foreign stocks make up more than half the world’s total stock-market value. You don’t want to overlook them. Invest 20% of your stock money in Vanguard Europe Pacific ETF (VEA), which mirrors the MSCI EAFE index, the most popular index of foreign stocks of developed nations. Expenses are just 0.16 %. It returned 32% over the past 12 months, trailing U.S. stocks because advanced foreign economies lagged the U.S. in recovering from the recession.

Put 10% of your stock money into emerging markets. Again, a Vanguard fund, Vanguard Emerging Markets Stock ETF (VWO), comes out on top, largely because it charges just 0.27% annually. It follows the MSCI Emerging Markets index. While the developed world slowly climbs out of the Great Recession, many emerging markets are growing like gangbusters. Low labor costs in emerging markets make it difficult for developed nations to compete in many arenas. Over the past 12 months, the fund soared 79%.

To complete your stock portfolio, invest 5% in real estate investment trusts, high-yielding companies that own property. Vanguard REIT Index ETF (VNQ), which charges 0.15% to mirror the MSCI U.S. REIT Index, returned 35% over the past 12 months. Unlike some real estate ETFs, this one invests solely in stock REITs (it doesn’t own REITs that invest in mortgages).

Commercial real estate remains in awful shape, but most large REITs that needed cash have already obtained it by issuing more stock or debt. That puts them in an enviable position compared with the mom-and-pop companies that have long dominated commercial real estate. Look for big REITs to acquire a lot of smaller real estate firms this year. What’s more, real estate helps diversify your investments.

A final word: This is anything but a buy-and-hold portfolio. Over the long term, undervalued stocks and stocks of small companies have been the clear winners. But given current valuations and the economic backdrop, I think the market will reward shares of the biggest and strongest companies this year and, within that category, the faster growers among them.